WCM Educational Recap #2: The Economic Cycle

Recapped by Alyssa Choi & Morgan Tannis

The Economic Cycle

This week, we dive into billionaire Ray Dalio’s template for understanding how the economy works!

Topic Spotlight

This week’s topic spotlight tied together container shipping, supply-crunch inflation, and central banking

• Since the onset of COVID-19, US imports have outpaced exports, leading to a rise in container shipping prices
• When importers pass these price increases along to consumers, inflation occurs
• To slow this inflation, the central bank may raise interest rates
• Click here to check out a great source of economic datasets which are downloadable to excel!

Ray Dalio

Ray Dalio is the manager and co-chief investment officer at Bridgewater Associates

• With $99Bn in AUM, Bridgewater is the largest investment fund in the world
• Bridgewater generates investment ideas using Ray Dalio’s economic template, which is what this week’s educational is about
• Click here to watch Ray Dalio explain how his template works

The Economy

In an economy, the production and consumption of goods and services are used to fulfill the needs of those living and operating within it.

Transactions

Transactions between buyers and sellers are the building blocks of the economy

• A transaction occurs when a buyer exchanges money or credit for a seller’s goods, services, or financial assets
• Total Spending = Money + Credit
• Price = Total Spending / Total Quantity
• The government is the largest buyer in the economy

Markets

A market is the aggregate of all transactions involving the exchange of money or credit for a single type of good or service

• Examples of markets include the wheat market, the car market, and the stock market
• The aggregate of all markets is the economy

Central Banking

Some of the most important players in the economy are central banks

• Central banks are closely connected to the government but have the authority to act at their own discretion
• Their purpose is to control inflation and keep unemployment low
• Central banks influence inflation, unemployment, and the broader economy by manipulating two important economic factors — interest rates and money supply
• Central banks also regulate member banks using cash and reserve requirements and act as a lender to commercial banks and the government in emergency situations

Interest Rates

Central banks control interest rates by setting the FFR (Federal Funds Rate)

• The FFR is the interest rate that commercial banks are permitted to charge when loaning cash to each other for short periods of time
• Commercial banks charge their customers interest rates higher than the FFR to generate a spread (return)
• Banks will never issue a loan at an interest rate lower than the FFR because they could loan the cash to another bank and earned the FFR instead

Money Supply

To increase the money supply, central banks print money and purchase government bonds

• To decrease the money supply, central banks sell bonds and remove the cash from the economy
• When central banks purchase government bonds, the government has new cash to use at its discretion
• This process is called an OPM (Open Market Transaction)

Lenders and Borrowers

Borrowing occurs when a buyer exchanges a promise to repay a seller’s cash

• This transaction simultaneously creates credit and debt
• Debt is a liability for the borrower and credit is an asset for the lender
• Interestingly, borrowers are not only borrowing money from someone else, they are borrowing money from their future selves because their future income will be reduced by principal and interest payments

Collateral

• If a borrower has collateral, they are more likely to be approved for a loan
• Collateral is an asset that the lender can seize control of if the borrower defaults on their debt

Why Debt is Important

When debt is used properly, it enables individuals and businesses to purchase productive assets that they wouldn’t otherwise be able to

• Productive assets increase productivity and generate economic growth

Interest Rates and Spending

Think about the interest rate on a loan as the price of the loan

• By the law of demand, when the price rises, the quantity demanded falls, and when the price falls, the quantity demanded rises
• So, when the central bank raises the target interest rate (the price of debt), demand for debt falls
• When demand for debt falls, spending on productive assets falls and growth slows
• When the central bank lowers the target interest rate, demand for debt rises, spending on productive assets rises, and growth increases
• Because one individual’s spending is another individual’s income, taking out a loan has a ripple effect throughout the economy as incomes rise and more productive assets are purchased

Productivity With Credit

Debt allows us to consume more than we produce, and forces us to consume less when we have to pay it back in the future

• This “debt swing” cycle can lead to long-term productivity growth

Short-Term Debt Cycle (5–8 years)

Expansion:

• Economic activity accelerates due to credit (borrowing)
• An optimistic outlook and higher standard of living
• Credit is cheap and widely, easily available
• Peak: Increased spending results in inflation (rising prices), leading to devaluation of currency and increased wage gap
• Central Bank wants to avoid excess inflation (>2%), so it raises interest rates to reduce borrowing and spending while increasing saving

Recession:

• Economic activity slows due to higher costs of borrowing and increasing saving returns, stabilizing currency and prices
• Credit is limited and expensive
• Trough: Decreased spending and incomes leads to deflation, which leads to a low standard of living
• In a depression (severe recession): Central Bank lowers interest rates to spur economic activity

Long-Term Debt Cycle (75–100 years)

Causes

• People have an inclination to borrow and spend more rather than pay back debt, especially when credit is easily available
• Eventually, debt rises faster than income, creating a debt burden
• Ex. The Great Depression in 1929

Deleveraging: Reducing the Debt Burden

Cut Spending

• Demand decreases, asset prices fall, the value of collateral drops, stock market crashes and gets squeezed, borrowers are no longer creditworthy and stop taking on new debt
• Businesses cut costs leading to higher unemployment and lower incomes
• Deflationary and increasing debt burden

Reduce Debt

• Many borrowers are unable to repay loans
• Banks squeezed from both sides as they are not paid back, but depositors try to withdraw their money in panic
• People and banks default on debt: failing to repay
• Debt restructuring: Lenders get paid back over a longer period of time, or at a lower interest rate

Redistribute Wealth

• Central Government collects fewer taxes as people have lower incomes
• Increases spending for unemployment benefits and stimulus plans to increase economic spending
• Must raise taxes on the wealthy or borrow money to fund this deficit

Print Money

• Central Bank uses printed money to buy financial assets and government bonds
• Drives up prices and asset values, making owners more creditworthy
• Inflationary and stimulates spending throughout the economy
• The four levers must be balanced
• The recovery phase of the long-term debt cycle lasts ~7–10 years, known as a “lost decade” (Ex. decade after the 2007–08 global financial crisis)

Previous Economic Cycle

Drivers of Rapid Expansion (2009–2015)

Quantitative Easing (QE)

• Central Bank printed money to purchase government and private securities

Low Interest Rates

• Near 0% until 2015; borrowing made attractive for consumers (purchases) and businesses (investments)

Corporate Tax Cuts

• Decreased burden for struggling firms, boosted equity

Drivers of Slower Expansion (2015–2020)

Problem:

• Huge U.S. government budget deficit and debt + overleveraged corporations led to high inflation, exacerbated by QE

Solutions:

• Began raising interest rates in 2015
• Fed sold off previously acquired debt
• Decreased government spending to slow down expansion

Now:

• All-time highs in the stock market; questions of how long this can be sustained as inflation rises and people become unable to repay their debts

Macroeconomic Tools

Monetary Policy

• Central Bank incentivizes or reduces borrowing and spending by manipulating interest rates and supply of money

Ex. Bank of Canada’s Response to COVID-19

• Lowered interest rates (current: 0.25%) so people and businesses are more willing to borrow and spend
• Launched liquidity facilities and purchase programs (involving buying different assets) to help struggling businesses
• Open market operations to continue purchasing long-term debt

Fiscal Policy

• Government targets the total level and compensation of spending by manipulating taxation and government spending

Ex. Government Response to COVID-19

• Policies like Families First Coronavirus Response Act; Coronavirus Air, Relief, and Economic Securities Act; Paycheck Protection and Health Care Enhancement Act to stimulate economic activity
• Impact on individuals: rise in consumer spending (Canada: -30% to -13%, Apr-Jun)
• Impact on businesses: few average loans were distributed for the first round of assistance; loans were paid out to large businesses but small businesses faced the brunt of COVID-19 detriment

Future Growth Estimations

Many factors aside from credit affect growth.

• Productivity (education, resource utilization) is highly correlated with future growth (Ex: high government spending, but low impact of spending leads to less growth)
• Value of a dollar & inflation
• Culture: how society views work and contribution to public goods
• Credit (Country’s debt): large debt hampers growth in the future as the country must pay it back

Key Takeaways

• Debt rising faster than income will lead to large, crushing debt burdens.
• Income rising faster than productivity will eventually render you uncompetitive.
• Raising productivity, in the long run, is most important.